Jan. 18 (Bloomberg) -- Hedge-fund managers treat themselves
to absolutely fabulous toys: Ken Griffin is fond of Ferraris,
Steve Cohen is known for his Damien Hirst pickled shark and ice
rink outfitted with its own Zamboni in a gabled cottage.

So where are the customers’ yachts?

“Who can name even one hedge fund investor whose fortune
is based on the hedge funds he successfully picked?” asks Simon
Lack in his stinging expose, “The Hedge Fund Mirage.”

If anyone is qualified to pose that question, it’s Lack,
whose Wall Street career lofted him through the multiple mergers
that begat JPMorgan Chase & Co. His answer ought to drive many
hedgehogs -- and their investors -- into hibernation.

Sitting on JPMorgan’s investment committee, Lack helped to
allocate more than $1 billion to promising hedge-fund managers,
the book says. His conclusion about the broader industry, stated
baldly on page 1, can be boiled down to one statistic.

“If all the money that’s ever been invested in hedge funds
had been put in Treasury bills instead, the results would have
been twice as good,” he writes.

Lack isn’t saying that hedge funds never reap superior
returns for investors. Far from it. He clearly admires John
Paulson’s bet against the U.S. housing bubble and George Soros’s
wager against the Bank of England. And the industry did perform
well and preserve capital during the 2000 to 2002 bear market,
which is why so many institutional investors threw money at
them, driving assets under management to more than $1.6
trillion, Lack says.

Flood of ‘08

Yet the star performers are outliers. Research shows that
“a few dozen have produced most of the investors’ returns,”
Lack says. And don’t forget the “thousand-year flood” of 2008,
when the hedge-fund industry “lost more money than all the
profits it had generated during the prior 10 years,” he writes.
So much for the “absolute, uncorrelated returns” they
promised: Investors would have done better by shoveling their
money into T-bills, earning 2.3 percent, Lack says.

Shunning simple average annual returns, Lack measures hedge
funds with an index weighted by assets, just as the stocks in
the Standard & Poor’s 500 Index are weighted by their market
value. This gives a better sense of the returns, he argues,
because investors in aggregate have invested more in the bigger
funds. Then he turns his attention to the real profit killer:
fees.

He starts with two data sets: annual assets under
management (as tracked by BarclayHedge since 1998) and returns
as measured by the HFR Global Hedge Fund Index, which is
weighted by assets. Next, he estimates fees using the standard
“2-and-20” formula -- a 2 percent management fee and 20
percent incentive fee.

Real Profit

This involves a few simplifications. Some managers, for
example, charge more than 2 and 20, some less. Yet the
methodology does reveal a clear picture of the total profit
hedge-fund investors received minus fees and the return they
could have gotten by parking their money in Treasury bills.

And that’s not the worst of it, Lack says. HFRX index
doesn’t account for factors such as “survivor bias,” meaning
that only surviving hedge funds report returns (just as the
victors write history, he says). Adjusting for those biases, the
annual fees sink to $324 billion, while the real investor
profits plunge to a negative $308 billion, he says.

Consider, too, the fees charged by funds of hedge funds,
used by roughly a third of hedge-fund investors, Lack says.
Throwing that into the mix, investors were left with $9 billion,
while the industry amassed $440 billion in fees, or 98 percent.

So Much, So Little

The risks and rewards are so cockeyed that Lack can’t
resist paraphrasing Winston Churchill’s encomium about Royal Air
Force fighter pilots during the Battle of Britain: “Never in
the history of Finance was so much charged by so many for so
little.”

If Lack’s calculations are wrong, he can kiss his career
goodbye. If he’s right -- and I think he is -- pension funds
have a lot of questions to answer.

Lack does more than crunch numbers in this book. He recalls
a chance JPMorgan had to invest with Bernie Madoff (they passed)
and an “opportunity” to do a tricky trade with Long-Term
Capital Management LP. LTCM’s Myron Scholes, of Black-Scholes
Option Pricing fame, offered to help price the deal. Lack
declined.

“Trading options with Myron Scholes didn’t sound like a
poker game I should join,” he says.

As damning as his analysis is, Lack ultimately concludes
that hedge-fund managers aren’t the villains of this sad story.
The real fault lies with the “supposedly sophisticated
investors” who fling so much money at funds with so little
skepticism and critical analysis.

“The Hedge Fund Mirage: The Illusion of Big Money and Why
It’s Too Good to Be True” (Wiley, 187 pages, $34.95, 23.99
pounds, 28 euros). To buy this book in North America, click
here.

(James Pressley writes for Muse, the arts and leisure
section of Bloomberg News. The opinions expressed are his own.)